Over the past 7 years I’ve frequently criticized the Fed’s predictions for inflation and RGDP growth. This is not based on my skill as a forecaster, I don’t have any. Rather I try to infer market forecasts, by looking at things like TIPS spreads (for inflation) and TIPS yields (for RGDP growth).

I do recognize that these market predictions can be flawed, for instance TIPS spreads fell to implausibly low levels during the banking crisis of late 2008, perhaps because T-bond prices were distorted by illiquidity in the asset markets. Nonetheless, during normal times I think TIPS spreads can be useful. Certainly the TIPS market correctly called the Fed’s earlier over-optimism about achieving 2% inflation.

But now I’m a bit torn, as the current TIPS spreads, about 1.3% on 5 year bonds, seems implausibly low to me. TIPS spreads are based on the CPI, which tends to run higher than the PCE inflation rate targeted by the Fed. So they are implicitly calling for barely over 1% PCE inflation. Here’s Steve Williamson discussing a recent post by Larry Summers:

We can use inflation swaps data, as Summers does; we can look at the break-even rates implied by the yields on nominal Treasury securities and TIPS; and we can look at survey measures. What do people who do forecasting for a living, and who have access to all of that data, say? The Philly Fed’s most recent Survey of Professional Forecasters [SPF] has predictions of PCE headline inflation for 2016 and 2017, respectively, of 1.8% and 1.9%, which is pretty close to the 2% PCE inflation target. A Wall Street Journal survey shows a CPI inflation forecast that seems roughly consistent with the December FOMC projections for PCE inflation. So, it seems that “most available data,” filtered through the minds and models of professional forecasters, suggests no less optimism than the FOMC is expressing in its projections, about achieving 2% inflation in the future.

This is an interesting way to frame the issue. Williamson talks about the fact that forecasters can incorporate market forecasts, whereas I’d tend to look at things in exactly the opposite direction. In an efficient market, asset prices reflect all available information, including the consensus of professional forecasters. I’d prefer the market forecast, if we could be sure that the asset prices/spreads actually reflected market expectations. But can we?

You might wonder why I am skeptical of the TIPS spreads, which seem to imply just over 1% PCE inflation over the next 5 years, given that PCE inflation has averaged just over 1% during the past 4 years. And indeed the trend has been downward. But I see this as reflecting the effects of lower commodity prices, especially oil. Since commodity prices tend to follow something close to a random walk, there’s no reason to extrapolate those declines into the future. I have no idea where oil will be in 5 years, but the best guess is probably not too far from where it is now. In that case, we might prefer to extrapolate the CPE core inflation rate, which has averaged about 1.5% over the past 5 years. But even that may be a bit too low, as it includes a period where the dollar strengthened signficantly in forex markets. On the other, other hand, maybe some of the impact of the strong dollar has not yet worked its way into core inflation, recall that PPP is a long run concept.

After reading Williamson’s post I looked up the track record of the SPF, and it looks to me like it made roughly the same sorts of mistakes as the Fed. Here are the headline PCE inflation forecasts, with actual numbers in parentheses. The forecasts were for Q4 over Q4 inflation, made in Q4 right before the year being forecast:

2008:Q4 1.8% (1.2%)

2009:Q4 1.3% (1.3%)

2010:Q4 1.4% (2.7%)

2011:Q4 1.7% (1.8%)

2012:Q4 2.0% (1.2%)

2013:Q4 1.9% (1.1%)

2014:Q4 1.8% (0.4%) estimated based on November over November

Too small a sample to draw any conclusions, but this does support one of Williamson’s complaints about Summers’ post. Williamson criticized Summers’ claim that the Fed treats the 2% inflation figure as a ceiling, not a target. Lots of my commenters agree on that point, partly based on the past few years. But I’ve never been fully convinced. Yes, the Fed has generally undershot inflation since 2008, but perhaps this was mostly an honest mistake. The fact that the SPF tends to have made very similar errors to the Fed in recent years, strongly suggests that these were in fact honest mistakes.

FWIW, here are some predictions:

1. Both the Fed and the SPF will continue to forecast roughly 2% inflation, in the years ahead.

2. At some point the SPF will stop being biased (if they are currently biased) and they’ll figure things out. At that point PCE inflation will begin averaging 2%.

3. But not yet. I think both the Fed and the SPF still put too much weight on Phillips Curve models of inflation, and thus I put some weight on the TIPS spreads.

4. But the 5 year TIPS spread seems too low to me, so I will split the difference and forecast about 1.5% PCE inflation for the next couple years, and then closer to 2% after that.

5. However when the next recession hits (and I have no idea when that will be) I’d expect inflation to again decline. And unless the Fed moves toward NGDP targeting (which makes inflation countercyclical), this undershoot may revive complaints that the Fed treats the 2% figure as a ceiling.

PS. If the Fed and the SPF are right about inflation expectations, then TIPS would seem like a much better investment than T-bonds. The expected 5-year return would be perhaps 80 basis points higher on TIPS, and they are if anything lower risk than T-bonds. The only downside is slightly less liquidity, but in an absolute sense TIPS are still a very large, deep and liquid market. For commenters who work in finance, why would something like an insurance company hold T-bonds instead of TIPS?

There are a couple problems with TIPS for institutional investors. First, while the market for TIPS is pretty liquid, it isn’t quite as liquid as Treasuries, and when you are measuring your swap spread in basis points with one decimal point, it can make a difference.

Second, inflation is not really a risk for institutional investors. If an asset manager is measured relative to a benchmark, then all they care about is performance relative that particular benchmark (whether S&P 500, a Fixed Income Aggregate Index, etc.), and however that benchmark compares to inflation is not really the asset manager’s problem. If an asset manager is measured on an absolute return basis, then it is nominal absolute return, not real absolute return.

Lastly, think about why someone buys Treasuries. Sure there are small investors who buy individual bonds and hold to maturity, and some “cash-like” funds that buy them for the (meager) return, but generally Treasuries are held as part of some other position. So maybe to satisfy a cash holding requirement for your entire portfolio, or borrowed and sold short to lever up a credit position. Since few other securities have any sort of inflation dependence, with TIPS you would end up paying more to get a worse match for your portfolio.

The inflation expectations in tips yields should be the mean expected outcome whereas forecast from the Fed, and likely the SPF, are the modal expected outcome, if expected inflation has a larger left tail then I can see that bringing down the mean, and is probably possible now. Nick Rowe pointed had a post a while back positing that the low expected inflation in tips spreads during the crises was possibly due to the left tail growing rather large, when there was talk of the “another Great Depression scale financial crises”.

Most people who work with tips yields assume a non-negligible liquidity premium in their yields which was a large driver of their price during the crises and is what the FOMC has publicly pointed to as the recent driver of changes in tips yields. This would lead to the raw spread to “bias” the expected inflation derived from tips spreads downward.

“If an asset manager is measured relative to a benchmark, then all they care about is performance relative that particular benchmark (whether S&P 500, a Fixed Income Aggregate Index, etc.), and however that benchmark compares to inflation is not really the asset manager’s problem.”

I don’t see why that matters. Suppose you expect the returns on TIPS will be greater than the returns on Treasuries, by 80 basis points.

That means the return would be greater relative to every benchmark in the world, wouldn’t it? What am I missing?

And why would a tiny bit less liquidity matter, when you expect to earn an extra 80 basis points? I don’t get it.

Joseph, Yes, the means and modes my differ quite a bit, but I doubt they do. I’m not even sure which direction has the bigger tails. Both negative 1% and 5% inflation seem very unlikely over the next 5 years.

TIPS have another interesting feature. They are inflation-protected bonds, not inflation-linked. This means that if there is deflation, TIPS coupons pay the full nominal amount, and do not discount the deflation on the coupon. I am not sure how this is calculated exactly[1], but one would expect that as the likelihood of deflation increases, then the value of TIPS relative to nominal bonds would increase. A TIP is basically a nominal bond + an deflation option, so the closer you get to the option strike price (0% inflation), then the option value starts rising above 0, thus understating inflation expectations if all you do is subtract nominal from TIPs yields.

A quick google yields the following FRBSF[2] study about the issue, and places the option value at around 150 basis points at the height of the panic, and to 41 basis points during 2009 (they seem to have used only data until 2010 or so). I am not an economist so I can’t comment on their methods, though.

[1] I think coupons can never be below face value, so an old bond could be deflated (after having been inflated during its lifetime) this year but a new one could not (as it has never experienced inflation, but I’m not sure. Confirmation by people that know welcome.
[2] http://www.frbsf.org/economic-research/files/wp12-07bk.pdf

“Inflation is not really a risk for institutional investors. If an asset manager is measured relative to a benchmark, then all they care about is performance relative that particular benchmark (whether S&P 500, a Fixed Income Aggregate Index, etc.), and however that benchmark compares to inflation is not really the asset manager’s problem.”

I will agree with you as it relates to asset managers.

However, Asset managers are not the only institutional fixed-income investors. Insurance companies and pension funds care about real returns. They have inflation sensitive forward liabilities they need to cover.

There is more than one way to hedge your inflation risk. In addition to TIPS you could buy buy commodities, REITs, or stocks and bonds of oil and gas producers, or non-dollar bonds for example.

S Sumner,
“I don’t see why that matters. Suppose you expect the returns on TIPS will be greater than the returns on Treasuries, by 80 basis points.

That means the return would be greater relative to every benchmark in the world, wouldn’t it? What am I missing?

And why would a tiny bit less liquidity matter, when you expect to earn an extra 80 basis points? I don’t get it.”

To a large degree, you are right, it doesn’t. If an asset manager thinks that TIPS are cheap relative to (nominal) Treasuries, he would buy TIPS and sell T-notes. But, TIPS are generally considered “out of index” assets, which means that the manager usually has some limitations on how much he will be allowed to buy, and out of index allocations tend to get more scrutiny by the clients, so he will have more ‘slpainin to do if things go poorly.

Could it be that if the Treasury decides to auction say $50 billion in total bonds, it is the Treasury that determines how that will be divided up between regular and TIPS bonds? So maybe Treasury decides to auction $40 billion in regular and $10 billion in TIPS? If TIPS were preferred by the buyers in that case you would expect them to sell at a different price.

Some other possibilities for low market inflation outlook or Treasury yields: an increasing global supply of capital, pushing down yields; or fear of recession and then deflation; or the official inflation measures increasingly overstate “true” inflation.

Maybe China money buying Treasuries figuring a weaker yuan in one or two years.

Or ask BIS. The shrinking inflation rates mean the Fed should tighten.

Scott, I think TIPS are fairly accurate here, but I don’t know of that is good news or bad news. Core minus rent inflation has been running along just over 1% for a couple years. Shelter inflation is up to 3% and rising. The Fed is clearly hawkish. A lot hinges on how much the mortgage market is able to normalize. If it doesn’t normalize, we have a high danger of a generalized non-shelter nominal shock. If it does normalize, there is a huge amount of pent up demand, new supply would be disinflationary, and non-shelter inflation would have to push pretty hard to counter it. It’s sort of the opposite of the energy inflation context, but a much larger proportion of the measure.

Re Fed and 2% target vs. ceiling: actually, the language of both Stanley Fischer and Janet Yellen suggests that 2% is viewed now as a ceiling. They never suggest that the Fed could run with the PCE at 2.5% for several years, no big deal. They do talk about “approaching” the 2% target.

“I have no idea where oil will be in 5 years, but the best guess is probably not too far from where it is now.”

Market is showing Jan ’21 at very close to $50. And yes, it is where there is a 50% chance of it being higher and a 50% chance of it being lower, and therefore 50 is the best estimate of future prices. (and since you agree, one day I am going to bring this very point into my inflation-interest rate argument…one day)

“Since commodity prices tend to follow something close to a random walk”

I really liked the “something close to” added in there.

To me, what is most interesting is to see the ‘leftist’ countries where their major/only source of revenue is oil. At what price does a country like Venezuela, who must ‘for the social good’ maintain jobs in the industry, who no longer believes in accounting or in markets, who has nothing else to sell, where do they shut in?? The lower it goes, do they just keep producing more and more for any revenue?

“But now I’m a bit torn, as the current TIPS spreads, about 1.3% on 5 year bonds, seems implausibly low to me.”

You will forever remain torn and surprised at TIPS spreads because you are purposefully evading the repeatedly mentioned fact that TIPS bonds contain an implicit inflation “option” that has value and lowers spreads and yields.

Where is inflation going to come from?? Brazil, China, and Russia are looking at recessions/slowdowns. Europe and the US are weak. Cheap energy is trickling through the system. Central bankers are globally tight with money. That 1% PCE we have seen might be a peak.

My interpretation, probably bad, is that TIPS spreads are carrying within them risk of recession. The 2% forecasts are probably not looking at what happens if China goes into serious trouble, or the US tech sector gets a correction. If we believe the fed has learned very little from the last decade, a recession would be met with insufficient stimulus, and zero inflation.

If you look at China numbers, or at what is happening in the NASDAQ to companies like Twitter and Square, interpreting that there’s doubt in the marketplace is not implausible.

Either way, it’s more believable to me than thinking TIPS spreads are so far out of whack.

Insurance company ALM programs are focused on duration, convexity, and cash flow matching (and some optionality and other “stuff”). Lots of liabilities are fixed, or floating with respect to some investment portfolio (e.g. VUL). So yes, IC’s aren’t exactly relative nor absolute investors, but because of the level of inflation sensitivity in an IC’s portfolio, few ALM models are going to end up allocating lots of capital to inflation sensitive instruments.

And pension funds are much more interested in hitting the F87/88 expected return on assets target than they are with actually funding the benefit /snark. But seriously the pension fund itself is basically an absolute investor, and their consultant is looking at funds generally as a relative investor (except for alternate investments, which are more absolute benchmarks).

@ ssumner: Suppose you expect the returns on TIPS will be greater than the returns on Treasuries, by 80 basis points.

I assume by “return” you mean the real yield on TIPS and the nominal yield on Treasuries? If so, then when the yield on TIPS is 80 bps higher than Treasuries, then that means that the market implies 80 bps of *de*flation (actually that’s a terrible oversimplification because at low levels of inflation or deflation, TIPS have an optionality that makes their yield better. But it also makes the computation of market implied inflation more difficult because you have to figure out the value of the option).

Anyways, if you calculate that ex option the real yield on TIPS is 80 bps greater than the nominal yield on Treasuries, and believe in the market implied 80 bps of deflation, then your real expected yield with Treasuries is the same as your real expected yield with TIPS. E.g., if the nominal yield on Treasuries is 1.2%, and the (ex option) real yield on TIPS is 2.0%, and inflation is -0.8%, then the real yield on Treasuries is also 2.0%.

I have explained the same thing, right down to the 0 put, several times. It won’t register. My simple rule of thumb… if you see free money lying around on the table, you are probably doing something wrong.

It is commonly argued that the Federal Reserve Bank (FRB) targets 2% inflation as a ceiling for inflation, not the median rate of inflation. It is said that this is the “revealed preference” of the FRB which is different from the “actual preference”. This is the same as arguing the American baseball players have a “revealed preference” for hitting singles instead of home runs. It is certainly true that many more singles are hit than home runs but that is not a matter of preference but ability. It is more likely that the economy of the United States is producing all of the inflation that it possibly can, which is generally less than 2%. The FRB is indeed “swinging for the fences” but it is only getting to first base. At least it is not striking out.

Felipe is correct to point out the deflation option embedded in TIPS prices. However, unfortunately this is in the wrong direction to explain the price variance if you believe as Scott does that TIPS are currently too cheap.

“It is more likely that the economy of the United States is producing all of the inflation that it possibly can, which is generally less than 2%. The FRB is indeed “swinging for the fences” but it is only getting to first base.”

I thought announcing a gigantic new QE4(at say 200 billion dollars of open market asset purchases per month plus 10 billion direct deposits) would help spur inflation more than raising rates. Do you disagree David de los angeles?

I have to agree with Njnnja. If investors buy treasuries for the purpose of matching nominal liabilities with nominal assets, then regular treasures would command lower real interest rates than TIPS and thus TIPS spreads would be artificially low.

That said, if the FED were to peg the TIPS spread as their means of inflation targeting, the inflation risk premium would be substantially reduced and the TIPS spread would become more representative of actual inflation forecasts.

That’s a big if. Because if the *market* is right, then the expected real return on Treasuries is exactly the same as the expected real return on TIPS.

It is not much more than a tautology that if you disagree with the market values of things, then you will find mispricings in the market. So if you disagree with the market implied value of inflation, you will find mispricings in inflation sensitive instruments. The 80 bps “mispricing” that you see is only there if you disagree with the market about the rate of inflation. Not to belabor the point, but if you disagree with the market’s valuation of sugary water, you will think that Coca-cola is mispriced. If you disagree with the market’s valuation of fancy little gadgets, you will think that Apple is mispriced. Etc.Etc.Etc.

But I would warn that doing so is generally a bad idea. EMH is pretty accurate to (at least) a first order approximation, and as @Derivs said: “if you see free money lying around on the table, you are probably doing something wrong.”

Firstly, liquidity in TIPS has deteriorated a great deal and continues to get worse every day. The liquidity discount is, therefore, large.

Secondly, with TIPS (and other so called Canadian-style inflation-linked bonds), only the principal payment is “inflation-protected”. This doesn’t imply that, with deflation, the value of a TIPS increases; it just means that its value stops decreasing as rapidly as it would have otherwise. That consideration is irrelevant anyways, since the cumulative deflation outcome is relatively far away.

Finally, the implicit suggestion that the fixed income mkt participants should get excited about N extra bps of yield (with N=80 or whatever) is a bit outdated. There are big things afoot which all add up to the idea that the liquidity/regulatory/etc penalty associated with owning a PoS like TIPS are much bigger than N. It’s a brave new fixed income market out there!

GDP fell off a cliff in December. But inflation targeting is not working, so GDP targeting could head off another recession. So, that means inflation targeting should hit a much higher mark. And in order for that to happen, the Fed should buy non financial assets. I doubt if they would but they should.

However, if is against the law for the Fed to buy non financial assets, what else could it buy to pump up inflation in the face of NGDP decline?

Everyone, Glad to see most people are more market monetarist than I am. I do recognize that many of you have the better argument–I’m just telling you what my gut instinct tells me. We’ll see what happens, I may well be wrong. Don’t have time to answer many comments today, as I spent the whole day starring in a major motion picture, which will be released in early March.

Felipe, That’s right, but because older bonds can be deflated, it’s possible to get around that problem when estimating the TIPS spread.

Thanks for that info Doug.

Derivs, Yes, I wrote this post a couple weeks ago, when oil was around $50. But good point. Even so, that gap is small compared to the drop from $100 in recent years.

Njnnja, No I meant 80 basis point higher according to the Fed/SPF. That is, including the inflation adjustment to TIPS.

On you latter comment, the Fed thinks the TIPS spread is not the actual market expectation, which for some reason they think is closer to 2%. That’s what confuses me. If the Fed thinks the market actually expects 2% inflation, why don’t they think insurance companies would hold TIPS rather than Treasuries?

David, If they couldn’t raise inflation then they obviously would not have raised interest rates last month.

Martinghoul, What is the bid ask spread for TIPS? Last time I looked it was small. Not disagreeing, it’s just an area I’m not well informed on.

ssumner, it depends… Bid/ask varies wildly depending on whether the security in question is a current on-the-run issue, its maturity and, obviously, the trade’s size. I know that various liquidity studies done by the Fed that are based on the changes in the width of the bid/offer spread concluded that the treasury mkt is fine and dandy, but, frankly, they mostly just make me laugh.

Indeed, you are correct. The effect does go the other way. Sorry for the confusion.

This makes me even less confident in the liquidity argument. Can it overcome the option effect, and then some?

Scott, I don’t think you can “get around” the problem. That would mean the option value is zero, and at least according to the paper I linked, it isn’t. There has to be more to the TIPS pricing if they are undervalued.

Liquidity may be one part, but I personally don’t buy it. A liquidity effect of more than 50 basis points is too large, as it would imply even more implausibly large premiums on many asset classes that are less liquid (ie, most of them).

“Pethokoukis: “A top Silicon Valley investor has written a bold essay in praise of income inequality””

I prefer not to express my opinions on income inequality as I always know I will be immediately discredited based on the fact that only people on the left side of the distribution are allowed to express opinions on that issue. Yesterday, I saw an article on how Bern is catching Hilary and I decided to see his website, particularly his musings on income inequality since that is what he is so being praised for. I saw the attached chart and just shook my head.

ssumner, apologies if I am mentioning something that you have already seen and considered, but I didn’t see this particular note referenced in either your post or the comments… I am not suggesting I agree with the authors’ conclusions, but at least it’s the right question.

“Derivs, Yes, I wrote this post a couple weeks ago, when oil was around $50. But good point. Even so, that gap is small compared to the drop from $100 in recent years.”

It is funny, but here is where reading ‘where’ prices are changing is very helpful. This is why I said several days ago, “if production does not start being shut in this thing will go to $1”, What needs to be looked at is what is happening to the shape of the curve.
In that other thread on inflation I was basically showing how forward curves are developed and that the spreads are predominately determined by interest rates. Those spreads should hold pretty well as people keep arbing them into place. In oil if you look at the spreads a few years out they all move to .10 – .15 cents month over month. Normal. You also see the market stopped/slowed coming down at the long-term end as price can only stay under production costs for so long. What people have difficulty understanding is how far it can move from those costs in the spot market.
So if you watch just the price change, you see the market developing this incredibly steep contango, and this can ONLY be possible if no one is finding storage to arb the inter-month spreads. i.e, If I can buy X for $30.44 and sell the exact same X for $31.52 ONLY 1 month later. For the love of god, I am all over that hand over fist. Who wants your tips at .00001 when I can make 3.5% in one month on oil (-minus a few bps for renting that tanker)???? And therin lies the info. Right now there is no storage. Every tanker is taken. The spreads can only get this wide because no one can arb it anymore. $20 or $40 next, I do not know, but the market is demanding production stop or it will force you to burn it at the wellhead for $0, because right now, where/how prices are changing, tells you that those molecules have no home.

The market always gets her way. Silly fools to think they know better than her and can therefore control markets.

Something similar to this, just in the opposite direction, is what happened when Amaranth blew themselves to pieces. They pushed out storage spreads that always were 24-40 cents to $3.50 where even crossing $1.00 sounded insane. By $1 all the physical storage was gone and no one could get in their way anymore. But as is usually the case, and deservedly so, getting out didn’t go so well for them.

On you latter comment, the Fed thinks the TIPS spread is not the actual market expectation, which for some reason they think is closer to 2%. That’s what confuses me. If the Fed thinks the market actually expects 2% inflation, why don’t they think insurance companies would hold TIPS rather than Treasuries?

I’m not sure that the Fed thinks that the TIPS spread isn’t the market expectation. Looking at the recent Fed minutes, they point out that “market-based measures of inflation compensation were still low” and then more specifically, point to TIPS: “Measures of in-flation compensation based on Treasury Inflation-Pro-tected Securities remained low.” So they seem to use TIPS as a (the?) “market-based measure of inflation.” They also mention that survey-based measures of inflation are higher, so they are seeing the same discrepancy between what experts expect versus what one can trade on, but rather than call the 2% survey value the “market expectation,” they seem to just be discounting the credibility of the market measure and going with they survey based measure instead.

I would defer to Martinghoul (whose reputation on other boards is exceptional) when it comes to the technicals of the TIPS market. But to your question, why would IC not invest in them? As I mentioned before, first, it doesn’t fit in their ALM program. So the only reason they would invest is because they think it is undervalued. But I would say that of all the potential sources of alpha out there, it’s just really hard to be comfortable that one has an edge at simply forecasting a straightforward macroeconomic variable like inflation better than everyone else.

You can only imagine how likely it is that some junior portfolio manager is going to get more capital allocated to him because he has a new model that predicts CPI, and wants to trade TIPS because he sees an 80 bps (!) discrepancy in the fundamentals.

To make an arbitrage trade on an 80bps differential attractive, I assume you’d want to lever it up. I wonder how easy it is to lever up a TIPS position. Are TIPS readily accepted for repo, for instance?

Another possible explanation is that the Fed is distorting the market. The Fed owns roughly 1/4 of outstanding Treasury notes, but only about 1/10 of outstanding TIPS, if I’m reading their balance sheet correctly.

ChrisA, The probability of a reversal has risen in recent weeks, but is still probably less than 20%.

Felipe, What I meant is that there are 5 year TIPS with some CPI inflation already built in, and that the probability of enough deflation to drive the price back to the original point is almost nil. Thus compare a long term TIPS with just 5 years left to maturity, to a newly issued 5 year TIPS. What’s the difference in yield?

Maybe Martingoul knows.

Martingoul, Thanks, I have seen some similar papers, although I don’t know enough to have strong views on the matter. Here’s a question that I just thought of:

Suppose you constructed a hybrid asset comprising TIPS and CPI swaps that took a short position on inflation. (Or is the correct term “synthetic asset”?) Wouldn’t it be possible to simulate a nominal Treasury bond of the same maturity? And then couldn’t we compare the return on that hybrid asset, with the T-bond yield, to determine how much of the difference was due to liquidity. After all, a TIPS plus an inflation swap would certainly be less liquid than just a T-bond. Or am I missing something obvious?

FWIW, market forecasts of inflation were dramatically superior to the Fed’s forecast in the September 2008 meeting, right when Fed policy became too tight (as even Bernanke has now admitted.) The Fed forecast “high” inflation, while the markets forecast 1.23% inflation over 5 years. They refused to cut rates from 2%, citing the risk of high inflation.

Derivs, Well I know very little about oil storage costs.

Njnnja, Doesn’t the Cleveland Fed say that the TIPS spread is not the market forecast, and that when they adjust the TIPS spread to reflect bias it is actually closer to 2%? I recall reading that, but am not certain.

If the Fed actually thinks the TIPS spread is the actual market expectation, I don’t see how they can justify such a dramatically different number. They might be a little smarter than the market (although I doubt even that) but a lot smarter?

o. nate, Good question. That why I asked people who work in places like insurance companies or pensions. I don’t know enough about finance to answer your question, but I simply wondered how they thought about the choice between a T-bond and TIPS, if they already planned to invest in one of the two.

I wasn’t thinking about speculators, just those already in the market for safe bonds.

“Suppose you constructed a hybrid asset comprising TIPS and CPI swaps that took a short position on inflation. (Or is the correct term “synthetic asset”?) Wouldn’t it be possible to simulate a nominal Treasury bond of the same maturity?”

Since everyone is deferring to MartinGhoul I’ll join the boat, grab me some popcorn, and wait for the answer but those look like 2 perfectly offsetting positions to me (short CPI + long TIPS). Or a 200 delta one (short or long both).

Just for fair value I ran 5yr TIPS vs 5 yr treasury and without modeling the option I had the 2 w/in 15 bps of fair value. Modeling the option would close that gap.

…but wait.. since it is a CPI ‘swap’ it would just pay the difference and not the full yield… you would be hedged against the linearity in the TIP but but the expiration p+l wouldn’t match against the bond.

Firstly, regarding the deflation floor, lemme preface everything below by stating that implying the price of this option (and, consequently, deflation probability) from the mkt prices of TIPS is more akin to art than science. So take whatever number I offer with a very large pinch of salt.

As per ssumner’s suggestion, here’s a reasonably simple comparison of a newly issued TIPS and an aged issue (for which the cumulative deflation option is extremely far out of the money and thus almost worthless). Specifically, the floor embedded in the current 5y TIPS (0.125% coupon, 04/2020 maturity) is worth arnd 5bps. It is worth arnd 1bp for its old neighbor (1.25% coupon 07/2020 maturity, issued in Jul 2010).

I am not sure what you’d be able to do with these numbers. The issue, as I mentioned, is these calculations are reasonably tricky to perform and depend heavily on the methodology used. The resulting inaccuracies, obviously, become more significant when the options in question are worth so little.

my recollection of LTCM back in 1998 was they’d have looked at this and gone long TIPS and short Treasuries. Then the 80 bps would move to 100bps. Then… it’s over. Even the smartest trades can backfire.

Actually appreciate it. Built a little model simply for curiosities sake and never felt like calculating that put. Brings me from 15 to 10.

I assumed Scott was thinking that he could replicate a 5yr note trading 1.73 by shorting a CPI swap at 1.39 and buying Tips at .34, therefore the payout appears to always match the notes at 1.73 as the CPI swap and TIP move one for one in opposite directions vs inflation.
Or, once again, I misunderstood his intentions.

OT – another nail in the coffin of Sumner’s monetarism. One of the bedrocks of monetarism is the steady share of labor in the economy, yet this has been debunked, see below. In short, let’s assume sticky wages, and employers will fire workers rather than force them to take a paycut. From the standpoint of the economy as a whole, so what? That’s the issue. In short, sticky wages (even if they exist, which they really don’t), don’t matter. Even shorter: we’re heading towards a ‘Star Trek’ economy where the machines do all the work. Labor does not matter. Nor ‘steady or rising prices’ for that matter. – RL PS–cited by Tyler Cowen yesterday.

“Labor Share Decline and the Capitalization of Intellectual Property Products” ∗
Dongya Koh University of Arkansas Raül Santaeul` alia-Llopis Washington University in St. Louis Universitat de Val` encia Yu Zheng City University of Hong Kong

April 2015 Abstract
We study the behavior of the US labor share over the past 65 years using new data from the post-2013 revision of the national income and product accounts and the fixed assets tables capitalizing intellectual property products (IPP). We find that IPP capital entirely explains the observed decline of the US labor share, which otherwise is secularly constant over the past 65 years for structures and equipment capital. The labor share decline simply reflects the fact that the US economy is undergoing a transition toward a larger IPP sector
The constancy of the labor share (LS), one of the great fantasies of contemporary macroeco- nomics, is finally gone: The LS declines. Using the most recent national income and product accounts (NIPA) data after the 2013 Bureau Economic Analysis (BEA) comprehensive revision, we find that, the US aggregate LS decreases from 0.68 in 1947 to 0.60 in 2013 (Figure 1). Compared with the LS implied by the pre-revision data (Elsby et al. (2013), Piketty and Zucman (2014) and Karabarbounis and Neiman (2014a)), the decline of the updated LS starts much ear- lier in (at least) the late 1940s and still continues. These findings shatter the alleged constancy of the LS (Kaldor (1957), Prescott (1986)), which is nothing short of “a bit of a miracle” in Keynes’ colorful language.

Don’t need to. Just need to know the components of a Futures spread. Go back somewhere safe, like 5 years, to where the curve looks normal. Know that cost of carry for one month is about $50*1%/12 and then the majority of the rest of the spread is your storage costs. So when you see the front month spreads explode, you know it is not cost of carry that broke, it is storage. That will only happen, to the extent it currently has, if there is no capacity to store. Reasoning from a price change.

If you told me in May that Corn is limit up 3 straight days, I could reason it is flooding in the Midwest.

Tell me hourly price of electricity in SoCal just went from $16 to $500 throughout the region and I can reason the Southwest is in for a blistering hot day. Tell me it only happened at one nodal point and I would know it was just a transmission problem.

Tell me it went from $16 to $27 and I know the system just turned on its Nat Gas generators.

Tell me Nat Gas is $50 at Chicago City gate and I know to put on my Balaclava without even having to turn on the weather channel.

Tell me contango is steepening in Crude…. and so on and so on…

That’s without even getting into the NECESSITY to work with price change to calculate std dev and build correlation matrices. And all the awesome insight you can derive from knowing those things.

Maybe, “be careful reasoning from a price change” is more accurate, but ‘NEVER’ is an absolute and as with most times one speaks in absolutes, incorrect.

ssumner, so your intuition is correct. There is a way to obtain some insight into the “theoretical” liquidity discount associated with TIPS. The relevant metric used by the mkt participants is called the “iota spread”. The problem with any such measure, however, is twofold. Firstly, your computation depends heavily on the accuracy of the inputs you use. Because liquidity has deteriorated, our ability to measure liquidity or lack thereof for liquidity-challenged markets is severely impaired (abuse of term intended). It’s all most devilishly circular. Secondly, pretty much any number that one obtains in such manner is going to include multiple premia. For instance, apart from liquidity, the “iota” spread will incorporate the additional credit risk premium associated with holding a TIPS in lieu of a nominal UST.

Martingoul, Thanks for that info on liquidity premia. If I read that accurately, when the liquidity premia are low, it may be hard to distinguish between two types of TIPS. But if I am correct, very low liquidity premia on both types of TIPS would suggest that it is unlikely to bias the TIPS spreads (TIPS/T-bonds) very much, where “very much” might be 50 to 100 basis points (as some are currently claiming is the spread between the actual TIPS spread and the actual market expected inflation rate.)

Bill, Yes, but that is certainly not what I am suggesting here. I agree that LTCM was too overconfident.

Ray, I did a post a while back making that claim (that more IP explains rising inequality. Glad to see my hunch confirmed.)

dtoh, You asked:

“Is there a monetary policy scenario where you could get 0% real growth and 4.5% inflation over a sustained period of time?”

Martingoul, Thanks for that info on liquidity premia. If I read that accurately, when the various TIPS liquidity premia are low, it may be hard to distinguish between two types of TIPS. But if I am correct, very low liquidity premia on BOTH types of TIPS would suggest that it is unlikely to bias the TIPS spreads (TIPS/T-bonds) very much, where “very much” might be 50 to 100 basis points (as some are currently claiming is the spread between the actual TIPS spread and the actual market expected inflation rate.)

Bill, Yes, but that is certainly not what I am suggesting here. I agree that LTCM was too overconfident.

Ray, I did a post a while back making that claim (that more IP explains rising inequality). Glad to see my hunch confirmed.

dtoh, You asked:

“Is there a monetary policy scenario where you could get 0% real growth and 4.5% inflation over a sustained period of time?”

Yes, in Japan. 🙂

Seriously, in the US is would be quite unlikely, for any expected period. I think it might have happened for a short period around 2008-09, if we had pegged NGDP growth at 4.5%.

Derivs, I agree that you can make those sorts of plausible inferences in many markets. But you need to really be aware of what you are doing, which even many economists fail to do. Recall Shiller’s recent claim that low interest rates are usually associated with high levels of investment.

Martingoul, The one issue I wish I knew more about was the design of prediction markets with an eye toward creating an asset price that most closely matches the actual market expectation of various macroeconomic variables. Thus I’ve advocated that the Fed create and subsidize trading in an NGDP futures market. But I’m not certain how this market should be designed for maximum accuracy, especially with the goal of having real time point estimates of one year forward NGDP announcements (say the initial announcement.) In the right column of this blog there’s a very primitive market, with the current growth rate reported. But it’s not a true market, as investors can only win small amounts, and can’t lose anything.

I was not familiar that the Cleveland Fed did so much research into inflation expectations but looking into it, it is pretty interesting. Starting here leads me to believe that the “closer to 2.0%” number that you recall is the results of the model presented in this paper.

Their model methodology seems pretty thorough, and you are correct that they don’t use TIPS for their market value. Rather, they look at inflation swaps to build their model (TIPS are only involved at all as a reasonableness test of the final model).

But even more important, they explicitly incorporate the market price of inflation risk so that they can adjust inflation swap prices to get the pure expectation. They use both survey inflation forecasts and inflation swap prices in the parameterization of their model to get this value (basically, survey forecasts are pure expectations while market rates are expectations plus inflation risk premium).

They say that the market expects a 1.8% inflation rate over 10 years because 1) their model uses inflation swaps instead of TIPS (but currently their model and TIPS are very similar so I don’t think that makes much of a difference right now), and 2) they calculate about 50 bps of inflation risk premium. FWIW their model estimates a market expected 1.46% inflation over the next year. Even 5 year market expectation is 1.66%. So the Fed definitely sees a short to medium term discrepancy.

ssumner, I know what you’re trying to achieve and I am very sympathetic. However, I am also rather pessimistic. As you may or may not be aware, various exchanges and mkt participants attempted to build a platform for inflation futures (should be easier than NGDP, theoretically). Unfortunately, that went nowhere in either US or Europe. Moreover, as the Fed never tires of reminding us, the fundamental irreducible issue you always end up having with all market-implied measures is that they’re measures of compensation, rather than pure expectations. In other words, they’re all risk-neutral quantities and would never remove the need for a discussion such as ours.

I figure the TIPS spread is just factoring in a fairly sizable probability for a 2011-style Euro Zone recession for the US. Fed over does rate increases, causes a small recession, refuses to make up for the resulting undershoot in inflation and NGDP.

Njnnja, Thanks for that info. So the 5 year number from the Cleveland model of 1.66% is well above the TIPS spread, but a bit below the Fed’s own internal forecast, if I got that right. Doesn’t the Fed expect around 1.8% over 5 years?

Martingoul, I wonder if futures markets are the wrong way to think about this. I’d liken my proposal more to an internal corporate prediction market, set up for the specific purpose of inferring expectations. I envision the Fed spending a substantial amount of money making it liquid.

For example, most people think the current non-existence of NGDP futures markets is a point against my plan, there seems to be little demand for this product. But in an odd way it’s a point in favor, as if there is little demand for hedging NGDP risk, doesn’t that suggest the market price is likely to be closer to the market expectation? In contrast, if there was a huge NGDP hedging demand, it might create a substantial risk premium.

In any case, I think this is one of those cases where we don’t want to let the perfect be the enemy of the good. A risk premium that is large in the finance literature, may not be large in a macro sense. For instance, a 100 basis point risk premium seems pretty large to me on a one year forward NGDP futures contract, given that NGDP is pretty inertial. But a 1% miss is not enough to cause a major macro problem. The Great Recession was caused by NGDP falling 8% below trend over a year, and normal recession might involve a 3% or 4% miss. If NGDP could be kept growing within a 3% to 5% range, we’d have a pretty good outcome in my view.

So with that in mind, I still think an artificial NGDP prediction market could be quite useful. If the Fed agreed to be the counter-party on all short trades at a 3% NGDP growth rate and all long trades at a 5% NGDP growth rate, then I would have gone short in late 2008, and made lots of money. But more likely I would not have made lots of money, as many other people would have seen the same opportunity, and the Fed would have changed policy aggressively enough to keep market NGDP forecasts in the desired 3% to 5% range.

I don’t see much downside–if the market is inefficient the Fed makes lots of profit off stupid traders like me. More likely, the 8% miss (800 basis points!) in 2009 doesn’t happen.

Justin, If by sizable you mean 10% or 20% chance I agree. If you mean 40% I don’t.

Looking at the Fed economic projections from December, the median PCE projection for 2016 is 1.6%, for 2017 is 1.9, for 2018 and later is 2.0. That’s about a 1.9% 5 year estimate. Only by using the low end of the reported central tendency is the Fed expectation about 1.8% for the next 5 years.

Even worse, the Cleveland model is based on CPI (market and survey forecasts). So a 1.66% Cleveland CPI model forecast is something like 1.3% PCE forecast? Model error doesn’t explain it either because the fit is pretty decent.

So let’s say that the Cleveland Fed model of market-implied 5-year expected PCE inflation is 1.3%, which when compared to the Fed’s own forecast of 1.9% is quite different. Even if one disagrees with some of the particulars of the Cleveland model, any analysis is going to use the same basic data and use the same sorts of adjustments (it’s a standard SV short rate interest rate model applied to nominal rates and inflation so even quibbles about, say, the selection of the innovation process probably isn’t going to change results too much). One must conclude that the Fed believes that it is correct and the market is wrong.

Njnnja, Thanks that’s helpful. If that’s correct, then you are right that the Fed is simply saying that the markets are wrong, not that there is a risk spread fudge factor. My mistake. Check out The Kocherlakota post linked to by Julius after my newest post.

Now that I have looked at the Cleveland Fed working paper, I am very much with Njnnja on this. In fact, you can see that they have inadvertently created their own measure of “TIPS liquidity discount” (simply the difference between the market and model-implied real yields). The way this spread has evolved through time very much agrees with my intuition arnd the evolution of the inflation-linked market.

> “Is there a monetary policy scenario where you could get 0% real growth and 4.5% inflation over a sustained period of time?”

Yes, in Japan. 🙂
Seriously, in the US is would be quite unlikely, for any expected period. I think it might have happened for a short period around 2008-09, if we had pegged NGDP growth at 4.5%.

I think I asked about a) “monetary policy” (because it’s easy to accomplish with a confiscatory tax (non-monetary) policy like in Japan, and b) I’m pretty sure it’s possible to have it for a short (non-“sustained”) period of time.

What I’m really curious about is whether you or anyone could engineer a monetary policy in the U.S. that would get you 4.5% growth all of which was nominal without any real growth for a sustained period of time.

That’s the answer I was trying to get. So therefore if you were to assume that supply side factors don’t change, it would make no difference whether the target for monetary policy was RGDPLT or NGDPLT…. I think.

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Welcome to a new blog on the endlessly perplexing problem of monetary policy. You’ll quickly notice that I am not a natural blogger, yet I feel compelled by recent events to give it a shot. Read more...

Bio

My name is Scott Sumner and I have taught economics at Bentley University for the past 27 years. I earned a BA in economics at Wisconsin and a PhD at Chicago. My research has been in the field of monetary economics, particularly the role of the gold standard in the Great Depression. I had just begun research on the relationship between cultural values and neoliberal reforms, when I got pulled back into monetary economics by the current crisis.